On August 16th, WMT reported very strong 2Q18 earnings (Chrome keeps warning me the Walmart investor web pages aren’t safe to access, so I’m not adding details). Wall Street seems to have taken this result as evidence that the company makeover to become a more effective competitor to Amazon is bearing enough fruit that we should be thinking of a “new,” secular growth WMT.

Maybe that’s right. But I think there’s a simpler, and likely more correct, interpretation.

WMT’s original aim was to provide affordable one-stop shopping to communities with a population of fewer than 250,000. It has since expanded into supermarkets, warehouse stores and, most recently, online sales. Its store footprint is very faint in the affluent Northeast and in southern California, however. And its core audience is not wealthy, standing somewhere below Target and above the dollar stores in terms of customer income.

This demographic has been hurt the worst by the one-two punch of recession and rapid technological change since 2000. My read of the stellar WMT figures is that they show less WMT’s change in structure than that the company’s customers are just now–nine years after the worst of the financial collapse–feeling secure enough to begin spending less cautiously.

This interpretation has three consequences: although Walmart is an extraordinary company, WMT may not be the growth vehicle that 2Q18 might suggest. Other formats, like the dollar stores or even TGT, that cater to a similar demographic may be more interesting. Finally, the idea that recovery is just now reaching the common man both justifies the Fed’s decade-long loose money policy–and suggests that at this point there’s little reason for it not to continue to raise short-term interest rates.

As I mentioned yesterday, one BIG problem with the traditional business cycle model (the one taught in business schools) is that although it explains what happens abroad, it no longer fits with behavior in the US economy–which is, after all, the biggest in the world (for believers in purchasing power parity, the second-biggest …after China).

The model says that lower interest rates energize business capital spending, which produces new hiring, which leads to higher consumer activity as new employees spend their paychecks.

Makes sense.

the US experience

In the US, however, consumer spending recovers first. Typically, soon after the Fed begins to lower interest rates, US consumers have been back in the malls, spending up a storm. Rather than industry lifting the consumer, the consumer pulls industry out of its slump.

How so?

Economists theorize that what’s at work in the US is the “wealth effect.” Two aspects:

–maybe lower rates are like Pavlov’s dinner bell ringing and consumers begin to salivate in advance of recovery (my personal take on this is idea that the office/plant grapevine signals that the worst is over, that layoffs have stopped and new hiring will soon begin)

–lower rates = house prices start to rise, as do bonds and stocks. So consumers feel wealthier as rates fall, because their accumulated assets (their wealth) are worth more.

The problem here is that we’ve had zero rates for eight years without seeing the traditional recession-ending spending surge

where’s the capital spending?

Whether capital spending is the locomotive or the caboose, it’s still arguably an integral part of the economic recovery train. Why haven’t we seen a capital spending surge in the US? Is the lack of capital spending an indication of continuing weakness in the US economy, as the traditional business cycle theory would suggest?

I think four factors are involved here, the sum of which suggests reality has sped far ahead of theory:

–the internet. Typically, there’d be a surge in construction of shopping malls as recovery gains speed. But as online commerce has developed, we’re finding that we already have maybe 20% too much bricks-and-mortar retail space

–globalization. Continuing industrialization in emerging economies like China during the last decade has decisively shifted lots of low-end US-based manufacturing abroad. In addition, I’m also willing to entertain the thought that crazy spending in China has produced an enduring glut of manufacturing capacity there, although I have no hard evidence

–software. For many (most?) US companies, the largest target for new investment spending is not bigger, newer plants but faster, more efficient software. The National Accounts, the government system of tallying economic progress, have no effective way of recording this expenditure for analysis. The traditional business cycle picture is similarly stuck in the world of fifty (or a hundred) years ago

–skilled vs. manual labor. This is a thorny issue, and one I have strong opinions about. Here, I think it’s enough to say that the traditional model doesn’t distinguish between a twenty-year old with a grade school education and a strong back vs. a college dropout like Mark Zuckerberg. A generation ago, the distinction wasn’t important. today, it’s crucial.

The easiest place to start is at the low point of the cycle–and to talk about every place in the world except the US.

the target for government policy

A typical rule governing policy action would be for a country to act so as to maintain the highest sustainable (that is, non-inflation-inducing) rate of economic growth.

the bottom

At its low point, activity in an economy is advancing at considerably less than that. The economy may even be contracting. The cause may be prior action by the government to slow the economy from a previous overheated state (policy actions are blunt tools: most often they overshoot their objective) or the economy may have been hit by an out-of-the-blue event, like an oil shock or a financial crisis.

In either case, companies are laying off workers, reducing inventories, closing now-unprofitable operations …all of which is causing the slowdown to feed on itself.

The traditional remedy to break the downward spiral is to lower interest rates–we might also describe this as lowering the cost of money by making a much larger quantity available to borrow.

What does this do?

In theory, and often also in practice, companies have a list of new capital projects they are ready to implement but which are unprofitable at the high interest rates/weak growth that accompany/trigger a slowdown. By lowering rates, the monetary authority makes at least some of those projects into moneymakers. So companies commit to new capital projects. They hire planners and construction firms; they buy machinery; they hire workers to staff new plants.

As these formerly unemployed workers get paychecks, they begin to consume more–they buy clothes, and then houses and new cars. They begin to eat restaurant meals and go on vacations again. As consumer-oriented service industries see their businesses picking up, they begin to hire again, too–adding to the new wave of consumer spending. At the same time, the supply chain begins to expand inventories to be able to satisfy rising demand. Similarly, manufacturers hire more workers and begin to expand their own productive capacity.

In this way, self-feeding slowdown turns into self-feeding expansion.

the top

At some point, the economy reaches full employment. Companies want to continue to expand because they now see many profitable investment projects. But there are no more unemployed workers. So firms begin to offer higher wages to bid workers away from other firms. They begin to raise prices to cover their higher costs. This activity doesn’t create more output, however. It only creates inflation.

Either in anticipation of, or in reaction to, budding inflation the monetary authority begins to raise interest rates to cool down the now feverish expansion. It keeps rates high until it begins to see signs of slowdown–inventory reductions, new project cancellations, layoffs.

The economy eventually reaches a low point …and the cycle begins again.

observations

–in the model just described, industry recovers first, followed by consumers. This happens in most of the world. In the US, however, as soon as interest rates begin to decline, the consumer typically begins to spend again. Business follows with a lag.

–conventional wisdom is that money policy actions need 12 – 18 months to take full effect. In the current situation, short-term interest rates have been effectively at zero for eight years (!!) without seeing a sharp surge in economic growth in either the US or the EU.

–economists have been concerned for years that there’s been no oomph in capital spending in the developed world, despite low rates. The traditional model explains he concern–business capital spending is thought to be a key element in any recovery.

For most of the thirty years I’ve been a professional investor, there has been a very dependable, high-beta link between world economic growth and world trade. When economies were expanding, trade would expand at a much higher rate; when economies were slowing, or contracting, developments in world trade were much more negative.

What was equally important for an investor was that although the economic data were clear from the outset, for many years equity investors in the US and Europe were slow to figure out what was going on. As a result, from the 1970s through the 1990s there was plenty of outperformance to be had simply by overweighting multinationals and global transport companies during economic expansions and underweighting them during slowdowns. Of course, one also had to give at least some consideration to currencies–that is, to make sure that a company had its revenues generally in harder currencies and its costs in weaker ones. Still the main idea was to exploit the high sensitivity of trade to world growth.

Today’s equity markets have caught on. It’s now part of most equity portfolio managers’ tool kits to favor multinationals and transports in upturns and shy away during downturns.

What I find interesting–and important–is that the economics seem to have changed over the last half-decade. Over the past few years, global trade has grown no faster than the world in general. It’s not 100% clear why this is so, but a reasonable guess is that the era of global production reshuffling between developed and developing nations to take advantage of lower labor costs, newer, more efficient plant and stronger management is over.

If this is right, and if I’m correct that stock markets haven’t really caught on to the new reality yet, then multinationals will be disappointing vs. expectations and the (more difficult) place to look for outperformance is with domestic firms within a given national arena.

There are also political implications (although I usually find political speculation irrelevant for making stock market gains). Maybe the anti-trade stance of both Hillary and Trump is a case of fighting the last war. The new economics would also suggest that the Trump campaign is much more deeply rooted in notions of white supremacy we thought had been left behind in the 1960s than we would like to believe.

The Bureau of Labor Statistics of the Labor Department released its latest JOLTS report on Wednesday.

The main results:

–nationwide job openings are now at 5.9 million, the highest figure in the 16 year history of the report. This is substantially above the 4.5 million level of 2006-07.

–the rate of new hires has been flat for about two years at just over 5 million monthly. While this is 5% – 10% below the rate of 2006-07, the very high number of job openings would have been consistent with an unemployment rate of 3% ten years ago. This seems to me to be a point in favor of the idea that the main impediment to filling jobs is finding workers with needed skills.

–3 million workers are voluntarily leaving their jobs monthly. This is a sign they’re confident of finding employment again without much difficulty. That’s back to the pre-recession levels of 2006, and almost double the recession lows.

All of this argues that the US is at or near full employment. On the other hand, however, there’s little sign of the upward pressure on wages that this situation would have produced in the past.

Whatever the reason for slow-rising wages, it seems to me there’s no reason in the employment figures for the Fed to maintain anything near the current emergency-room-low level of short-term interest rates.

This morning at 8:30 edt the Bureau of Labor Statistics of the Labor Department released its monthly Employment Situation. This was a so-so report.

The economy added +151,000 new jobs last month. Revisions to the prior two months were -1,000, or insignificant. Wages were up, but only slightly, maintaining their growth of about 2.4% annually. Service industries continued to gain; manufacturing and construction were flattish.

The results did fall short of Wall Street economists’ estimates of a +181,000 advance, but to my mind this says more about the economists and the difficulty of forecasting the jobs figure precisely than it does about the jobs.

It there’s one thing I take from it, it’s that the period of turbocharged jobs gains–well over +200,000 a month–we were experiencing earlier in the year is now behind us. If I were forced to attribute this relative slowdown to anything, it would be the strength of the dollar.

For me, the most curious thing about the report is that it appears to have sparked a rally on Wall Street, on the notion that this report makes it less likely that the Fed will raise interest rates later this month. This makes little sense to me, although I’ll take an up day rather than a down one any time. Personally, I think the Fed risks accusations of trying to influence the election if it acts before November, so not matter what its rhetoric it’s unlikely to move now. Looking at the character of gaining stocks, it’s primarily smaller doing better than larger, something that mostly happens when rates are rising.

This is the first time in a long while I’ve been nonplussed by market movements.